Markets wrestle with late-cycle crosswinds

In a rare tug of war, both equities and government bonds have rallied this year as financial markets wrestle with the implications of a synchronized global slowdown.

In our April equity market overview, we dissect the main issues underlying the ongoing equity/bond conflict.

As the chart below illustrates, equities have typically struggled relative to government bonds during past periods of weakening economic growth. Indeed, the steady decline in leading indicators has weighed on the year-over-year gains of US stocks (represented by the Russell 1000) relative to those of US Treasury bonds this year—although equities have marginally outperformed Treasuries recently.

Heeding signals differently

Equity and bond markets have been at loggerheads for most of this year. For equities, the catalysts have been the global loosening of financial conditions and rising hopes that the global economy can weather tougher macro conditions ahead. Global FTSE Russell Financial Conditions Indicator scores have fallen significantly from their November 2018 peaks, particularly in the US, and are now broadly neutral.1 The resilience of the US economy and recent signs that China’s slowdown may have bottomed have also helped.

But these easier financial conditions are mainly the outcome of the sharp pullback in government bonds yields and market-implied interest-rate expectations (see chart below), both largely a reaction to the more pessimistic economic prognoses and abrupt about-face in Federal Reserve and European Central Bank policy direction.

The flattening (and brief, partial inversion in late March) of the US Treasury yield curve, which has historically heralded a weakening economy, also indicates a lack of investor confidence in future growth. In our analysis, the deteriorating economic outlook—not falling breakeven inflation expectations—was the primary driver of the steep drop in nominal government bond yields in the US, UK, Germany and Japan from their highs on January 20.

Historical link: yield curve and EPS cycle

The continued downtrend in consensus forecasts for both GDP and inflation in 2019 point to lower nominal GDP growth and taller hurdles for revenue gains.Indeed, consensus 2019 revenue growth forecasts have edged lower over the past three months, with the FTSE UK, Asia Pacific ex Japan and the Russell 2000 seeing the sharpest downgrades.

The backdrop also implies tougher going for earnings growth. As shown in the chart below, the flattening of the US Treasury yield curve has historically tended to precede slowdowns in EPS growth by around two years, while sustained inversions have typically presaged EPS declines. Recently, 12-month-forward consensus EPS growth forecasts for the US have been closely following the US yield curve lower.

Recent economic data have been mixed and first-quarter earnings season is in the early stages. Forward 12-month earnings multiples in most developed markets are now back to their third-quarter 2018 levels, though still below early 2018 highs. It is important to assess the equity outlook within the context of this evolving macroeconomic environment. Given the lessons of past late-cycle eras, incoming data suggest continued crosswinds for risk assets.

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1 To gauge the extent of changes in financial conditions across the regions, we use a Z-scoring methodology that compares the current reading of each variable against its longer-term average, measuring these divergences in terms of standard deviations, which are clustered into bands 1 (loose) through 5 (tight).

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